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Fiscal Desentralisation and Sustainable Development: Lesson from Local

Government Levels in Indonesia
Article in Asia-Pacific journal of rural development · July 2016

DOI: 10.1177/1018529120160101
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Fiscal Desentralisation and Sustainable Development:
Lesson from Local Government Levels in Indonesia
Rosdiana Sijabat
Department of Business Administration, Faculty of Economics and Business,
Atma Jaya Catholic University of Indonesia
Jalan Jenderal Sudirman No 51, Jakarta, Indonesia.
Corresponding authour: rosdiana_sijabat@yahoo.com; rosdiana.sijabat@atmajaya.ac.id
© Authour(s)
OIDA International Journal of Sustainable Development, Ontario International Development Agency, Canada
ISSN 1923-6654 (print) ISSN 1923-6662 (online)
Available at http://www.ssrn.com/link/OIDA-Intl-Journal-Sustainable-Dev.html
Abstract: Indonesia introduced fiscal desentralisation when the central government enacted Law
No. 25/1999 on fiscal balance between the central government and the local governments. This
law was later revised as Law No. 33/2004 and is widely known as the ‘new direction of fiscal
relationship’ which guides the intergovernmental financial relationship between central and local
government in Indonesia (Brojonegoro & Asanuma, 2003; Suharyo, 2009). According to the law,
local governments have two major sources of revenues to finance their expenditures: own-source
revenues and intergovernmental transfers. Own-source revenues are revenues raised by local
governments from their local sources, consists of taxes, levies, proceeds from the management of
regional assets set aside for the purpose, and other source of revenues. While intergovernmental
transfers consist of Revenue Sharing from natural resources and taxes, General Allocation Funds
(Dana Alokasi Umum, or DAU), and Specific Allocation Funds (Dana Alokasi Khusus, DAK).
The fiscal desentralisation law established principles on the intergovernmental financial
relationship between central government and local governments, which take the forms of
devolution, deconcentration, and co-administration of tasks. Through those forms, most authority
and responsibility of the central government was devolved to local governments, including the
financial responsibility over the provision of public goods and services at local levels.
This study examines the arguments in favor of the impact of fiscal desentralisation on the
economic development at local levels through the public financing capacity. The methodological
approach was qualitative and quantitative modes of inquiry. The analysis on the fiscal budget
includes the revenues and expenditures assignments, the trends on the local government
expenditures, revenue desentralisation and financing capacity, as well as the roles of
intergovernmental transfers within the local budget. This study was undertaken upon the economic
arguments on fiscal desentralisation to increase the revenues or fiscal autonomy of sub-national
governments (Falleti, 2005) and provides autonomy to local governments in the provision and
financing of public goods (Brueckner, 2008). Fiscal decentralisation exists when sub-national
governments have powers given to them by the constitution or by legislation, to raise taxes and/or
carry out spending activities within clearly established legal criteria (Tanzi, 2000). This study
therefore seeks to examine whether fiscal desentralisation in Indonesia increases the financing
capacity of local governments, thus promoting local economic development.
The results from this study demonstrate that the practice of desentralisation in Indonesia has
shown that various reforms have affected the political and administrative system in Indonesia and
also the arrangements of authority and financial responsibility between the central government,
and the local governments (province and district/city). Under desentralisation policy, the central
government gives authority in most areas of governance to local governments. It is however, the
central government that retains responsibility for national planning, control on national
development, intergovernmental fiscal arrangements, the state administration and economic
institutions system, training and human resource empowerment, utilization of natural resources,
strategic high level technology, conservation, and national standardization. Such arrangements
40 Sijabat./ OIDA International Journal of Sustainable Development 09:03 (2016)
have changed the mechanism of accountability among central and local governments in Indonesia.
Fiscal data analysis performed for provinces, districts and cities in Indonesia indicate that most
local governments are still highly dependent on the fiscal transfers from the national governments
in performing their public financing functions. As such, the sustainability of local development
can be achieved in the long run.
Keywords: Governments, decentralization, fiscal, transfer
Introduction
I
ndonesia introduced decentralisation policy in 1999 when the central government enacted two laws on
decentralisation. The first was Law No. 25/1999 on fiscal balance between the central government and the local
governments. This law was later revised as Law No. 33/2004 and is widely known as the ‘new direction’ which
guides the intergovernmental financial relationship between central and local government in Indonesia (Brojonegoro
& Asanuma, 2003; Suharyo, 2009). According to the law, local governments have two major sources of revenues to
finance their expenditures: own-source revenues and intergovernmental transfers. Own-source revenues are
revenues raised by local governments from their local sources, consists of taxes, levies, proceeds from the
management of regional assets set aside for the purpose, and other source of revenues. While intergovernmental
transfers consist of Revenue Sharing from natural resources and taxes, General Allocation Funds (Dana Alokasi
Umum, or DAU), and Specific Allocation Funds (Dana Alokasi Khusus, DAK). The fiscal decentralisation law
established principles on the intergovernmental financial relationship between central government and local
governments, which take the forms of devolution, deconcentration, and co-administration of tasks. Through those
forms, most authority of the central government was devolved to local governments. Devolution of authority to local
governments has altered the structure of revenue and expenditure of local governments.
The Conceptualisation of Fiscal Decentralisation
The literature on fiscal decentralisation is closely related to fiscal federalism 1(Bardhan, 2002, p.187) and it is a
subfield of public finance (Oates, 1999, p.1120). The key issues in the fiscal federalism literature are the
responsibilities and the fiscal instruments between levels of government that address which functions and
instruments are best to decentralise and which are best placed in the higher level of government. In other words, it
arranges how expenditures and revenues are allocated across different levels of the administration. A key issue in
fiscal federalism is the arrangement of intergovernmental fiscal structures to improve the functioning of the public
sector (Oates, 2008). In particular, it focuses on how fiscal decentralisation affects fiscal stability, accountability,
public sector efficiency, democracy, government quality, and economic growth. According to the fiscal federalism
literature, fiscal decentralisation can increase efficiency and accountability in resource allocation. The two basic
arguments are: (i) local governments are better positioned geographically to provide public goods than are central
governments. Local governments can thus be more responsive to local preferences and needs; and (ii) pressure from
inter-jurisdictional competition may motivate local governments to be more innovative and accountable to their
residents. Inter-jurisdictional competition refers to situations where local governments compete with each other to
attract (or retain) residents and capital to their jurisdictions. If residents can choose among a large number of
districts, they would tend to favor districts that produce higher quality public services for a given local tax liability
or have a lower local tax liability for a given level of quality (Oates, 1972).
The literature on fiscal decentralisation can be divided into three categories (Cheikbossian, 2008). The first category
was pioneered by Tiebout (1956); it suggests that allocation of public resources would be efficient if such services
are provided (and paid for) by the governments responsible for those resources. This view is based on the following
assumptions: (i) given that tastes and willingness to pay differ for geographical, cultural and historical reasons,
demand for local public services varies across locations (however, local preferences are reasonably homogeneous).
If these assumptions are valid, the central provision of local public goods (if it tends to be uniform across the
country), is unlikely to please anybody; and (ii) decentralisation would result in every local government providing a
different bundle of local public services, each such service bundle reflecting local preferences.
In its pure form, Tiebout’s argument implies that mobility of voters is sufficient to ensure efficient allocation of
public resources. In Tiebout’s analysis, taxpayers move in order to avoid higher taxes and to advantage themselves
1
The terms federalism and decentralisation are used synonymously in this study.
Sijabat./ OIDA International Journal of Sustainable Development 09:03 (2016) 41
through inter-jurisdictional competition, thereby limiting the excessive taxing power of governments. Assuming
people are mobile, therefore, competition for mobile people should match bundles of public goods to citizens’
preferences.2 Tiebout claimed that in a system with many jurisdictions, competition among local jurisdictions would
ensure efficiency in the production of local public goods and also in the distribution of total population over
communities. Tiebout’s theory on fiscal federalism also focuses on the economic efficiency of intergovernmental
relationships. In his theory, Tiebout provided an explanation of the advantages of distributing power to the lowest
level of government. By distributing some functions to the lower government levels, for example the provision of
public services, the degree of efficiency in the allocation of resources would increase. Over the long term, efficiency
gains from the local delivery of public services would lead to faster local, as well as national, economic growth
(Oates, 1972). Local provision might also be a way to reduce the free-rider problem,3 by inducing people to reveal
their preferences for public expenditure. Here, people reveal the strength of their taste for publicly provided goods
through their choice of jurisdiction in which to live.
The second strand of the literature on fiscal decentralisation focuses on inter-jurisdictional spillover theory,4 also
known as spillover effects.5 This theory is constructed based on the view that more resources should be allocated to
regions that undertake public expenditure benefiting residents of other regions and not only their own residents. This
is with particular regard to the provision of public services. If travel costs are low, public goods are non-excludable
where residents can obtain utility from the public goods provided in their own municipality as well as from those
supplied in neighboring municipalities. Consequently, all residents of that municipality are able to consume the full
benefits of the public goods provision because they cannot be excluded from the benefits. Thus, if there are
spillovers from local public goods provision, residents of one municipality may migrate outside their municipality
and enjoy the services provided elsewhere. A key point in spillovers literature suggests that spillover benefits that
may occur from fiscal decentralisation can be achieved when lower-level jurisdictions of government ensure
cooperation among one another in providing public goods and services. Such cooperation is important to avoid free
riding in the provision of public services. The third branch of the literature focuses on the concept of fiscal
equalisation. Fiscal equalisation involves a system for addressing fiscal disparities and seeks optimal power-sharing
between central and local governments. It refers to the transfer of money from central governments to local
governments (Brilliantes & Tiu Sonco II, 2007) and aims to reduce the incentives for migration from relatively poor
regions to relatively rich regions (Buchanan, 2001, p.11). Addressing fiscal equalisation in Indonesia, Hofman et al.
(2006) pointed out that the need for fiscal equalisation is based on the fact that only the richest sub-national
governments will typically have enough revenues with some reasonable level of revenue effort to finance a basic set
of expenditure responsibilities/needs.
Arguments for Fiscal Decentralisation
The widely-known arguments for fiscal decentralisation are: (1) economic efficiency because local governments are
better positioned than national governments to deliver public services given their information advantage, this is
known as the preference-matching argument; and (2) population mobility and competition among local governments
for delivery of public services will ensure the matching of preferences of local communities and local governments
(Oates; 1972; Tiebout, 1956, as cited in Davoodi & Zou, 1998, p.244). Further, Tiebout and Oates divided the basic
economic argument on fiscal decentralisation into two strands. First, decentralisation will increase economic
efficiency because local governments are in better positions than the national government to deliver public services
because of the information advantage. As a result, local governments are more capable than central governments in
getting the information on local preferences and needs (Faguet, 2001). Second, population mobility and competition
among local governments for delivery of public services will ensure the matching of preferences of local
communities and local governments. This matching of preferences may improve allocative efficiency because public
services provided by the local government will be better matched to the preferences of the residents of those
localities (Lockwood, 2006).
In addition to these arguments, de Mello (2004, pp.7-9) suggested broader arguments for fiscal decentralisation
which include not only the economic benefit effects of fiscal decentralisation, but others including social benefits
2
In the literature, this is known as the preference-matching argument.
3
Free-riding may occur when consumers can take advantage of public goods without contributing sufficiently to
their creation (Musgrave & Musgrave, 1980, p.57).
4
See Oates (1999) for further discussion.
5
In economic literature, spillover effects may also be called as externalities (for example, Jaffe, Trajtenberg, &
Fogarty, 2000).
and public sector activities such as:

• fiscal decentralisation enables sub-national governments to take account of local differences in
culture, environment, endowment of natural resources, and economic and social institutions;
• information on local preferences and needs can be extracted more cheaply and accurately by local
governments, which are closer to the people and hence more identified with local causes;
• bringing expenditure assignments closer to revenue sources can enhance accountability and
transparency in government actions;
• fiscal decentralisation can help promote streamlining public sector activities and the development of
local democratic traditions;
• shortening the ‘informational distance’ between the providers and recipients of public goods and
services can reduce information costs and boost public-sector efficiency in service delivery; and
• by promoting allocative efficiency, fiscal decentralisation can influence macroeconomic governance,
promote local growth and poverty alleviation directly as well as through spillovers.
Pillars of Fiscal Decentralisation
Literature on fiscal federalism suggests two measures of fiscal decentralisation: (1) the share of expenditure and
revenue collection between sub-national governments and the central government; and (2) the percentage of sub-
national revenue and central government transfers. These measurements are arranged as four pillars of fiscal
decentralisation: (a) expenditure assignment; (b) revenue assignment; (c) intergovernmental transfers; and (4) sub-
national borrowing.6
Figure 1. Pillars of fiscal decentralisation
Pillar 1 Pillar 2 Pillar 3 Pillar 4

Expenditure Revenue Intergovernmental transfers Sub-national Borrowing
Source:Assignment
Own figure Assignment and grants
Expenditure Assignment and its Principles

A key challenge in fiscal decentralisation is how to design optimal expenditure assignments among levels of
government. In this context, expenditure assignment means how spending should be spread among levels of
government, or what expenditures should be retained by the central government, and what expenditures should be
transferred to sub-national levels of government. What is clear in the literature is that the assignment of expenditure
responsibility should precede revenue autonomy, particularly taxing power. This is because the division of taxing
power, besides being based on principles of tax assignment, should be determined by the requirements of different
spending agencies. Decentralisation of tax powers based on expenditure responsibilities is desired so that sub-
national governments do not have to rely exclusively on intergovernmental transfers to finance their expenditures.
The linking of revenue and expenditure decisions at lower levels of government is considered important to preserve
the incentive to provide public services in a cost-effective manner (Shah, 1994). Sidik (2007, pp.190-192) provided
two different approaches in expenditure assignments: the ’expenditure-led’ approach, and the ‘revenue-led’
approach. Under the first approach, functions are first designated as the clear responsibility of one or another level
of government on a mutually exclusive basis. The designation is based on objective criteria such as the degree of
local impact of the function in question, considerations of policy and administrative uniformity, general technical
and managerial capacity, the existence of spatial externalities or spillovers associated with the function, and of
economies of scale, among other considerations.
6
While it is noted that sub-national government borrowing is one of the pillars of fiscal decentralisation, this
subject, however, is not discussed in detail in this study. For the purpose of this study, discussion of the pillars of
fiscal decentralisation was only made for the other three pillars. Sub-national borrowing was not included in the
discussion since local governments in Indonesia do not often utilise sub-national borrowing to fill local revenue
shortfalls. More importantly, Law No. 33/2004 does not allow local governments to directly use sub-national
borrowing from foreign sources.
Thus, public functions such as primary education, local general hospitals and refuse collection would be assigned to
local governments as having primarily local impact, and being within management capacities at that level; specialist
secondary schools, regional specialist hospitals, and river and water resource management might be assigned to the
provincial level, given their substantial interregional impacts; religious affairs and justice would be reserved as
central functions, requiring policy uniformity, and given their nationwide impacts. In any case, once the assignment
of functions is agreed, revenue-source allocations between levels, and among regional governments at each level,
are then tailored accordingly. In contrast to the expenditure-led approach, under the revenue-led approach, public
revenue resources are first allocated in a general way between levels of government essentially as the result of a
political bargain struck between centralist and regionalist power interests. Political trade-offs also strongly influence
the allocation of resources among regional governments at each level, as reflected in the systems of inter-
governmental transfers. In the subsequent assignment of functions, while consideration of the principles mentioned
above in connection with the expenditure-led approach are still relevant, regional fiscal capacities become a
prominent consideration. While a general scheme for the allocation of functions between levels may be formulated,
fiscal capacity disparities between individual regions may well mean that not all places can finance their designated
functions, leading to direct higher-level government interventions in services provision.
Revenue Assignment
In theory, fiscal decentralisation would bring sub-national government closer to societies, thus it will be more
responsive to societies’ preferences regarding quantity and quality of public goods and services. To meet these
objectives, it is important for local government to have the authority and responsibility to finance their own local
services (Sidik, 2007). However, to determine which taxes are best suited for different levels of governments is not
easy considering efficiency and equity. Broadly speaking, the principles of revenue assignments (taxes) are
developed based on Musgrave (1959) and Musgrave and Musgrave (1989) who offered a comprehensive theory of
the state and public finance. According to Musgrave, there are three fiscal functions of government: providing
public goods and services (resource allocation), redistributing income in order to ensure income distribution (income
redistribution), and stabilising economic activities in order to reduce business cycle fluctuations (macroeconomic
stabilisation). Musgrave’s idea is known as ‘three functions of government activities’ that can be used to guide
revenue assignments across government levels. According to Musgrave, central governments must be responsible
for income redistribution and macroeconomic stabilisation, whereas resource allocation could be assigned to all
levels of government.
Therefore, several taxes should be assigned to the central government as they can be used to secure both income
redistribution and macroeconomic stabilization at the national level. These taxes include personal taxes with
progressive rates and corporate income, taxes that are suitable for purposes of stabilization policy, and all tax bases
which are distributed highly unequally among sub-jurisdictions. In exercising those functions, Musgrave suggests
that revenue assignment should be transferred to three levels of government: central level, regional levels, and local
levels.7 At sub-national levels, Oates (1972, 1996) addressed tax arrangements which should be assigned to this
level. According to Oates, middle and especially lower levels of government should tax those bases which have low
inter-jurisdictional-mobility because high Inter-jurisdictional-mobility tax bases make taxation difficult for sub-
national governments. Musgrave and Oates’s views, above, have been criticised. Their assumptions, arguments and
conclusions, which assume that lower levels of government are unconcerned with income redistribution is
questioned. In practice, local governments in many countries are really concerned with income redistribution, for
instance in education and health care sectors; and local governments in fact make little use of benefit taxes.
Musgrave and Oates’s views have also been criticised since their approach takes only the three usual governmental
levels into account (central, regional and local). In many countries, the geographical area covered by many locally-
provided (public) goods and services do not always coincide with the borders of jurisdictions (Bird, Dafflon,
Jeanrenaud & Kirchgassner, 2003).
Intergovernmental Transfers and Grants
As noted earlier, a significant feature of decentralisation is the transfer of responsibility over the function of public
services delivery to the local government. Transfer of such responsibility has to be accompanied with transfer of
revenue to the lower levels of governments to bridge the gap between spending and revenues of these lower levels of
7
Musgrave’s opinion in this issue is known as‘multilevel finance’.
government (de Mello, 2000). The arrangement of revenue transfers among the levels of government are known as
intergovernmental fiscal transfers (Brilliantes & Tiu Sonco II, 2007), which aims to compensate for vertical fiscal
imbalances and to offset horizontal fiscal disparities among government tiers (Musgrave, 1959; Oates, 1972).
Transfer of revenues is crucial, particularly in developing and in transition countries (Rodden, Eskeland & Litvack,
2003). In such countries, even though decentralisation has assigned revenue autonomy to local governments, they
are still dependent on central government funding in performing their public responsibility; in many cases, financial
resources from national to sub-national levels of government are still the major source of sub-national revenues. In
similar vein, Shah (2007) indicated that intergovernmental transfer and grants finance are about 60% of sub-national
expenditures in developing countries and transition economies and about a third of such expenditures in member
countries of the OECD. Hofman and Guerra (n.d) assessed whether there is a systemic relation between fiscal
disparities and disparities in service delivery indicators. To examine their hypothesis, Hofman and Guerra used a
simple regression approach to test the impact of expenditures per capita on social outcome indicators including the
Human Development Index (HDI), persons per hospital beds, life expectancy, and literacy rates in some East Asia
countries, including China, Indonesia and Vietnam. The estimation showed that most countries in their study have a
modest significant correlation between social indicators and sub-national expenditures.
The literature suggests various objectives for intergovernmental transfer. First, intergovernmental transfer aims to
redistribute income in order to correct fiscal imbalances that exist when fiscal capacity does not match fiscal need.
Fiscal capacity refers to the potential ability of local governments to fund their public functions (based upon a
standardised basket of public goods and services) from their own revenue sources (Richard & Tarasov, 2004;
(Martinez-Vazquez & Boex, 1997), whilst fiscal need, or expenditure need, is the amount that would have to be
spent on residents to provide services at par with the national average (Yilmaz, Hoo, Nagowski, Rueben &
Tannenwald, 2006). Thus, fiscal capacity is revenue capacity relative to a locality’s expenditure need. Fiscal
imbalances can be divided into two types: (1) vertical imbalances; and (2) horizontal imbalances. Vertical
imbalances refer to a situation where sub-national government is financially dependent upon national government
revenues to support their expenditures (Bouton, Gassner & Verardi, 2008; Bahl & Wallace, 2007). Vertical
imbalance occurs when sub-national government revenues do not match their expenditure responsibilities. Central
governments usually offset vertical imbalances by transferring a portion of their tax revenues to local government.
Such transfer is important to avoid poor provision of public services occurring because of vertical imbalances (Fiva,
2006). Horizontal imbalances indicate that revenue capacity and expenditure needs vary among local governments
where some local governments can fund expenditure more easily than others (Brilliantes & Tiu Sonco II, 2007).
Therefore, different sub-national governments and different regions may face different cost and demand pressures as
they attempt to meet their assigned expenditure responsibilities. Where central government can mitigate vertical
imbalances by transferring its own funds to local governments, transfer mechanisms to address horizontal
imbalances are often more complicated than those addressing vertical imbalances.
The second objective of intergovernmental transfers is political benefit. Intergovernmental transfers to local
government are provided to support local government to achieve development objectives that directly promote
economic growth and efficiency in resource allocation such as providing more public goods and services which
provide spillover benefits to residents of other areas. In addition, local governments are also encouraged to promote
equal opportunity and quality in the provision of public services, even for the poorest regions. On many occasions,
transfers from the national level are used to ensure that national priorities will be met in all sub-national government
jurisdictions (Bahl, Boex & Martinez-Vazquez, 2001; ADB, 2003, as cited in Brilliantes & Tiu Sonco II 2007,
pp.104-105).
Intergovernmental transfers fall into two broad categories, namely, general-purpose transfers and specific-purpose
transfers8 (Shah, 2007, p.2).
8
In Indonesia, General-purpose Transfers is called Dana Alokasi Umum (DAU), whereas Specific-purpose Transfers
is known as Dana Alokasi Khusus (DAK).
Figure 2. Basic taxonomy of intergovernmental transfer
Transfers
General-Purpose Transfers Selective-Purpose Transfers
Non-matching Matching
Open-ended
Closed
Source: Own figure
General-purpose Transfers (GPTs)

GPTs, also known as general grants or unconditional grants, refer to a set of funds transferred from central to lower
governments without any conditions set on the use of the transfers. Thus, local governments can allocate GPTs for
any expenditure programs according to need. Usually mandated by law, GPTs are provided as all-purpose budget
support; they are termed block transfers when used to provide broad support in the general area of sub-national
expenditures while allowing recipients discretion in allocating the funds among specific uses. The basic aim of this
transfer is to preserve local autonomy and enhance inter-jurisdictional equity. Many empirical studies show that
GPTs are used to achieve vertical balance among regions. Once central government has transferred money to a local
government, it will shift the local government budget line on some public goods (for example, spending on
education and health). In Figure 3, it is shown by shifting the initial budget line of local government (AB) upward
and to the right by the amount of the grant (AC=BD), creating a new budget line (CD). Since the transfer can only
be spent on any combination of public goods or services (for example, health and education), or used to provide tax
relief to residents, thus the transfer does not affect prices of health relative to prices of education (price effect), but
only creates the higher spending of local government on these public services (income effect) as indicated by the
new budget line.9 It tends to the flypaper effect (Shah, 2007). The flypaper effect occurs when the portion of
transfers retained for greater local spending tends to exceed local government’s own revenue, or, for political and
bureaucratic reasons, transfers to local governments tend to result in more local spending than would have occurred
had the funds been transferred directly to local residents (i.e., bypassing local government). It shows the increase of
expenditures is higher when financed by general-purpose transfers than by financing through the locality’s own
resources (Aragon & Gayoso, 2005).
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9
In this context, income effect refers to such situations where transfers from higher levels of government are used to
subsidize public goods or services. Subsidies on these services give the community more resources, some of which
may go to acquire more of the assisted service.
Figure 3. Effect of unconditional non-matching grant

Spending on Health
U2
U1
0 B D
Spending on Education
Source: Adapted from Shah (1994), as cited in Shah (2007, p.3)
Specific-purpose Transfers (SPTs)

SPTs are conditional transfers, designated for a specific public expenditure program. They are intended to provide
incentives for government to undertake specific programs or mandatory activities. These transfers typically specify
the type of expenditures that can be financed (input-based conditionality). They may also require attainment of
certain results in service delivery (output-based conditionality). Therefore, specific-purpose transfers are often used
to ensure minimum standards in the provision of public goods and services. Specific-purpose transfers can be seen
as two kinds: matching transfers and non-matching transfers.
Matching Transfers
In this scheme, local government as recipient is required to spend some of its own funds on the public goods or
services for which the transfer is provided, therefore, this transfer is also called a cost-sharing program. The
transfers provide an additional amount of funding for such goods or services to match the amount provided by the
local government. Such transfers can be open-ended (no limit on matching funds) and closed-ended. These funds are
assistance funding in nature; they are required to be spent for specific purposes. Such transfers have two impacts on
the recipient: (i) price effects, and (ii) income or substitution effects.10 Both effects stimulate expenditures on the
subsidised public goods and services. As described in Figure 4, the initial budget line is AB. This line indicates how
a local government allocates its money for the provision of public services (for instance in health and education).
The best combination of public spending can be seen at M, where the initial budget line intersects the indifference
curve (U1).
10
Price effects occur when a provider of public goods receives a grant used to provide certain public goods, or put
another way, the grant creates a subsidised public good(s). Therefore, such grants have affected the price as
between the subsidised public good and the unsubsidised one. Substitution effect occurs when transfers have
changed the relative price of certain public goods or services as compared to other goods or services; the community
acquires more subsidised goods or services from a given budget.
Figure 4. Effect of matching transfers
A’
A
Spending on Health
BL3
BL2 N
BL1 M
U2
U1
0 J1 J3 J2 B B’ C
Source: Adapted from Shah (1994) as cited in Shah (2007)
At that point, the local government spent money on health services as OBL1 and education as 0J1. When local
government spent 25% of the specific matching-grants on health, the budget line shifted to AC, creating a new
equilibrium point at N (where AC crosses U2). This implies that the amount of money allocated in these public
services has increased and improved access to such services, since U2> U1.
The specific-matching grants may improve the provision of public goods or services, both subsidised and
unsubsidised. As specific-matching grants can be spent on certain public goods or services that are included in the
grants, the local government now can allocate more money to finance other public goods or services that are not
included in the grant scheme. Specific-matching grants can be divided into two types: open-ended matching grants
and closed-ended matching grants. Open-ended matching grants are those where no limit is placed on available
assistance thorough matching provisions; there is no maximum amount of grant funding that a community can
receive from this grant type. In this scheme, the amount of money that local government receives is dependent on
what they spend. Central government agrees to ‘match’ local spending at a certain percentage. These grants are well-
suited for correcting inefficiencies in the provision of public goods and services arising from benefit spillovers or
externalities.11
By comparing the two types of matching grants, it can be seen that an open-ended matching grant is at least as
stimulative as, and sometimes more stimulative than, a closed-ended matching grant. A closed-ended matching grant
is equivalent to an open-ended matching grant below the maximum. Beyond the maximum, a closed-ended matching
grant is equivalent to a lump-sum grant and is therefore less stimulative than an open-ended matching grant.
However, both grants increase the median voter’s income (income effect) and reduce the median voter’s marginal
tax-price (substitution effect). The local government or recipient is likely to desire an open-ended matching grant, as
this grant allows recipients to determine which public expenditure can be financed by the grant. So the recipient has
more flexibility to spend the money, based on its preference and priority, in the context of its local development.
Open-ended matching grants are used to compensate for spillover benefits, while closed-ended grants are used to
promote specific public expenditures.
Non-matching Transfers
This transfer does not require the government receiving the transfers to spend any of its own funds on the good or
11
Benefit spillover, or positive externality, occurs when services provided and financed by a local government also
benefit citizens of other local jurisdictions not contributing to what their citizens receive from the spillover.
service for which the grant is provided. Figure 5 illustrates how the non-matching transfers affect the recipient’s
budget. The initial budget line of a local government is AB given its existing budget. When the local government
receives non-matching transfers, it shifts the budget line upward to AC. From this point, any additional money that
is transferred to the local government will create a new budget line (ACD) showing an income effect on the local
government. When local government places a priority on a certain public service to be financed (such as health), the
matching grants would have impact on that service as many as AC=OE. Put another way, the recipient is able to
increase, for example, health service provision from OA’ to OA.
Figure 5. Effect of conditional non-matching grant
A C
Spending on Health
A’
U2
U1
0 E B D
Source: Adapted from Shah (1994) as cited in Shah (2007, p.5)
In summary, matching transfers are more stimulative than non-matching transfers of the same amount. Unlike non-
matching transfers that only have income effects to society, matching transfers have two effects: 1) it increases total
resources available to the community (the income effect), but also 2) reduces the tax-price of the public service to
the community (the substitution effect), providing an incentive for the community to substitute the public service,
which is now cheaper, for other public goods and services.
The Practice of Fiscal Decentralisation in Indonesia
As explained earlier, fiscal decentralisation has changed fiscal relationship between central government and local
governments in Indonesia. Such changes impact the revenues and expenditures of local governments. The following
parts provide the trends on fiscal decentralisation indicators of provinces, district/city governments in Indonesia.
Revenue and expenditure as percentages of GDRP12 at district and city levels across Indonesia between 2001 and
2008 are shown in Figure 6. During this period, an increase in the size of district governments is clearly evident,
both in terms of total revenue size and total expenditure in all districts and cities. On average, the increase of the
revenue is about 45%, slightly higher than the increase in the expenditure which is approximately 42% from 2001 to
2008. In 2001, both revenue and expenditure as percentages of GDRP was at 12.7%, this increased marginally to
about 15% in 2002. From 2004, revenue as a percentage of GDRP was higher than expenditure as a percentage of
GDRP which reached 57.9% in 2008, whilst expenditure as a percentage of GDRP was about 54.7% at the time.
The increase in the revenue of district and city governments during the period is largely due to intergovernmental
fiscal transfers or balancing funds13 in total revenues. As will be discussed in the next section, total balancing funds
which are transferred by the central government to local governments (provinces, districts and cities) accounted for
about 86.8%, while revenues that were collected from their own jurisdictions, i.e. own-source revenues was
12
GDRP stands for Gross Domestic Regional Product.
13
The term ‘balancing funds’ are used interchangeably with ‘intergovernmental fiscal transfers” or equalisation
funds’ throughout this study.
abysmally low accounted only about 5.5% between 2001 and 2008. This clearly indicates that district and city
governments are very much dependent upon the fiscal transfers from other tiers of government. The steady increase
in expenditure size of district and city governments cannot be claimed as an evidence of the improvement in
financing capacity because majority of district and city governments’ expenditure are funded by external financial
sources.
Figure 6.Total revenues and expenditures as a percentage of GDRP in all districts/cities (Average, 2001-2008)
Source: own calculations based on data from Ministry of Finance.
To show the aggregate revenue as percentages of GDRP of district and city governments based on the jurisdictional
variation, the revenue of district and city is grouped based on main islands in Indonesia14 (Table 1). From 2001 to
2008, revenue as percentage of GDRP has increased in all districts and cities. As seen in the table, districts and cities
in the eastern part of Indonesia such as Nusa Tenggara Barat, Nusa Tenggara Timur, Maluku, Maluku Utara, Papua
and Papua Utara recorded the highest increase in total revenue as a percentage of GDRP from about 27.1% in 2001
to 94.1% in 2008 with an average increase about 58.5% during that period. The location of the highest revenue as a
percentage of GDRP in Nusa Tenggara, Maluku and Papua Islands shows that districts and cities in these islands are
financially very reliant on fiscal transfers from central and provincial government. As will be explored later, nearly
95% of revenues of districts and cities in those islands came from balancing funds from higher governments.
Sulawesi, Gorontalo and Kalimantan were in next highest with an average total revenue as percentage of GDRP of
30.2% and 29.2% in 2001-2008 respectively. While revenues as a percentage of GDRP in district and cities in
Kalimantan islands were approximately 29.2% in 2001-2008. In Jawa, Bali and SumateraIslands, the revenue size
ranged from 24.5% in 2001 to 17.2% in 2008. Based on the spatial analysis on the revenue size of government
measured as total revenues as a percentage of GDRP, it can be concluded that most districts and cities in the eastern
part of Indonesia have a relatively larger government compared to other districts and cities in other islands.
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14
The division of the islands is based on the official division as used by the Statistics Office of Indonesia.
Table 1.Total revenue size of district and city governments for main Islands (Average 2001-2010, %)
Island 2001 2002 2003 2004 2005 2006 2007 2008

Sumatera
Western
11.7 13.6 16.8 17.0 16.1 26.2 44.6 53.4
Java and Bali
8.5 10.8 12.7 12.5 11.9 17.0 29.0 41.6
Kalimantan
11.1 16.3 20.5 19.8 19.0 27.0 62.0 57.7
Middle
Sulawesi and Gorontalo
14.3 18.7 21.1 23.2 24.1 39.7 44.6 56.1
Nusa Tenggara, Maluku &
Eastern
27.1 35.5 43.3 45.9 51.0 97.9 73.3 94.1
Papua
The structure of revenue for the period 2001-2008 is shown by Figure 7. In this figure, comparison on the three
sources of revenue is shown: Own-source revenues, balancing funds and other source of revenues, all as a
percentage of GDRP. Broadly speaking, it suggests that the revenue of district/city government has increased
between 2001 and 2008. The increase was largely driven by balancing funds from central and provincial
governments. In all districts, balancing funds as a percentage of GDRP has increased annually from only about
12.8% in 2001 to approximately just over 50% in 2008. Own-source revenues, as the very useful indicator of
financial independence of local government, and other revenues are very small. As seen among districts and cities,
own-source revenues and also other revenues as percentage of GDRP had remained very low with less than 5%
every year from 2001 to 2008. This evidence shows a large imbalance between revenue raising power and
expenditure responsibilities of district and cities governments. A higher proportion of balancing funds in the total
revenue is also an indication that public financing on goods and services at the districts level are largely financed by
fiscal transfers from higher government levels. As such, the aim of fiscal decentralisation to give more fiscal
autonomy for local governments and to encourage self-financing appears to have not yet been achieved.
Figure 7. Different measures of the revenue size of district governments (Average, 2001-2008 %)
*as a percentage of GDRP

Source: own figure based on data from Ministry of Finance.
Table 2 disaggregates each revenue sources of district and city government based on main islands in Indonesia. As
seen in the table, most districts and cities with the higher revenue size of government are located in eastern part of
Indonesia including Nusa Tenggara, Maluku and Papua (58.5%) and followed by Sulawesi (30.2%) and Kalimantan
(29.2%) from 2001 to 2008. When calculated as own-source revenues as a percentage of GDRP, the highest
percentage is found in Nusa Tenggara, Maluku, Papua, Jawa and Bali with an average size of 1.9% every year.
Based on own-source revenues as a percentage of GDRP in all districts and cities, it can be seen that revenue raising
capacity is significantly small, with an average below 2%. As such, it suggests that revenue increases locally in these
districts and cities was too small to have a meaningful impact in mobilising local economy. Relatively similar spatial
distibution of the revenue size of government calculated as balancing funds as a percentage of GDRP is also found.
As presented in table, districts and cities in Nusa Tenggara, Maluku and Papua have the highest balancing funds as
share of GDRP with about 53.6% from 2001 to 2001, followed by districts and cities in Sulawesi and Gorontalo
with an average at 27.6% and Kalimantan with approximately 26% balancing funds of its GDRP.
Table 2. Three measures of the revenue size of district and city governments, average 2001-2008, (%)
Island Total revenue Own-source revenues Balancing funds

as % of GDRP as % of GDRP as % of GDRP
Sumatera 24.9 1.7 22.4
Western
Jawa & Bali 18.0 1.9 15.2
Kalimantan 29.2 1.6 26.0
Middle
Sulawesi 30.2 1.5 27.6
Eastern
Nusa Tenggara, Maluku
58.5 1.9 53.6
& Papua
Source: own calculations based on data from Ministry of Finance
In addition, the expenditure structure is also measured by using capital expenditure as a percentage of GDRP and
current (routine) expenditure as a percentage of GDRP as displayed in Figure 8. Using capital expenditure and
current is particulary significant to capture the different approaches used by the local government in the provision of
public goods and services. As indicated in the figure, current expenditure relative to GDRP have increased steadly
with an average about 19.2% from 2001 to 2008. With a slightly different rate, capital expenditure relative to GDRP
has also increase with an average of 9.2% over the same period, but current expenditure had constantly larger than
capital expenditure as percentage of GDRP in 2001-2008. Overall, current expenditure as a share of GDRP has a
steady increase, whilst capital expenditure had fluctuated moderalty. In the beginning of fiscal decentralisation in
2001, current expenditure reached about 8.4% of GDRP, while capital expenditure was only about half of current
expenditure which approximately at 4.2% of GDRP. In 2008, current expenditure as propotion of GDRP was still
larger then capital expenditure accounted to about 35.6% of GDRP, while capital expenditure was only about 19.1%
at the same time. This data raises some concerns. First, considerable variation between current expenditure and
capital expenditure reflects that budget priorities at district/city level has largely been devoted to running the
government administration rather than spending more on productive sectors under capital expenditure allocation. As
found in the budget allocation, a susbtantial amount of the current expenditure at districts and cities is used to cover
salaries and wages of the government employees. Second, a broad gap on the allocaton of current and capital
expenditure is also somewhat politics. As found by Tirtosuharto (2010, p.304), in his study on 26 districts and cities
between 1996-2005, funding for capital allocation for purposes such as human investment and technological
resources is actually available, but there is evidence that districts and cities tend to allocate more funding to current
expenditure and discreationary expenditure, either to benefit themselves or their political constituents by awarding
lucrative government contracts.
Figure 8.Current and capital expenditures in all districts and cities, average, 2001-2008
Share of capital expenditure and current expenditure as percentage of GDRP based on main islands is shown in
Figure 9. Of the two expenditure categories, current expenditure had remained dominant in district and city
expenditure indicating very little productive economy activies in those regions. As shown, districts and cities with
higher capital expenditure and current expenditure as percentage of GDRP are located in eastern part of Indonesia
with capital and current expenditrure as percentages was approximately 20.1% and 22.6% between 2001 and 2008.
Current expenditure in these regions was almost doubled than other districts and cities in different islands. A
significant amount of capital expenditure in eastern part of Indonesia could be driven by a significant increase in the
capital expenditure in Papua due to allocation of the special autonomy funds (Dana Otonomi Khusus) which are
mostly allocated for infrastrucre financing especially during the first few years since the special allocation funds
were given to Papua (World Bank, 2005)15.
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15
The Special Autonomy Fund is given to provinces which have special autonomy status (status otonomi khusus).
Nanggroe Aceh Darussalam and Papua are granted Special Autonomy Status since decentralisation. Papua entitles to
special autonomy funds as stipulated by with Law No. 21/2001, Papua received special autonomy funds at the first
time in in 2002, and province distributed larger share of the special autonomy fund to district/city government
across since 2003 (World Bank, 2005, p.22). Two other provinces with special autonomy status are D.I. Jogjakarta
and DKI. Jakarta, these provinces were given the special status prior to decentralisation era.
Figure 4.Current and capital expenditures by main islands, average, 2001-2008
Revenue Decentralisation and Financing Capacity of District and City Governments

As suggested in the literature on fiscal federalism, the transfer of authority and responsibility from national to local
governments cannot be meaningful unless local governments possess adequate financing. Thus, the central
government promulgated Law No 25 of 1999, which was revised to Law No. 33/2004 regarding the Fiscal
Balancing between Central and Local Governments. This law sets out a framework for the redistribution of revenues
between central and local governments where local governments are given considerably greater authority and
responsibility to manage their own budgets and also to raise their own revenues to help offset the expenditures
arising from decentralisation (Barr, Resosudarmo, McCarthy & Dermawan, 2006, p.11).
The revenue assignment is stipulated in Law No. 33/2004, Chapter III, Article 2. According to this law, sources of
state finances are made available to the regional government in the implementation of decentralisation based on the
transfer of tasks from the central government to regional governments with due regard to fiscal stability and balance.
Further, in Article 4, it is stated that delegation of authority in the implementation of deconcentration and/or co-
administration tasks from the central to local governments shall be followed with the provision of funds. This is why
the principle view on the fiscal law is termed, ‘Finance Follows Functions’ which means that the transfer of
government functions to local governments is accompanied with various transfers over financial sources (Sidik,
2007, p.415). Specifically, in Chapter III, Article 155 of Law No. 32/2004 and Chapter V, Article 5-6 of Law No.
33/2004, local governments’ revenue is derived from three sources: (1) own-source revenues; (2) balancing funds or
intergovernmental transfers; and (3) other local government income. Own-source revenues is comprised of local
government taxes, levies, proceeds from the management of local assets set aside for the purpose, and other own-
source revenues. The latter consists of proceeds from sales of local assets not set aside, current account service,
interest income, profits from difference in the exchange rate of the Rupiah against foreign currencies, and
commissions, discounts and other forms of income arising from sales and or procurement of goods and services by
the local government.
Law No. 25/1999 or Law No. 34/2004, provides revenue autonomy to local government in Indonesia. Revenue
autonomy implies that local governments have the freedom to decide about the source and volume of resources that
can be sought from their own region (Bahl, 2008). Under decentralisation, the autonomy of local governments to
seek new source revenues is underpinned with the enactment of Law No. 28/2009 regarding Local Taxes and
Levies. In particular, these regulations stipulate that provincial and district governments are allowed to impose some
taxes and levies.16 From the law, it is seen that there is opportunity for local governments to introduce taxation in
their regions and determine tax rates, tax bases and other tax parameters based on the regulations. Under the revenue
assignment, it is postulated that local governments should be able to increase their own-source revenues. Law No.
33/2004 assigns some revenue resources to local governments. To the greatest extent possible, the local government
should finance their obligatory and discretionary functions from their local taxes or other local government revenue
sources (Bird, 2000). Revenue composition of all districts and cities is presented in Figure 10 which shows that
district and city governments have not utilised the revenue-raising opportunities given to them under the fiscal
decentralisation law as own-source revenues only made about 7.7% of the total revenues of the local government.
Rather, the local governments are depending largely on balancing funds from the central and provincial
governments which accounted to 86.8%.
Figure 10. Revenues as percentage of total revenues, average, 2001-2008
Other source of revenues, 5.5%
Balancing funds, 86.8%
Own-source Revenue, 7.7%
Table 3 exhibits the composition of revenue of district and city government from 2001 to 2008. Overall, districts and
cities revenue rose from about 76,610 trillion IDR in 2000 to 264,387 trillion IDR in 2008 with an overwhelming
share of total revenues is obtained from balancing funds. According to fiscal decentralisation Law No. 33/2004,
Own-source revenue aims at providing authority to the districts and cities government in financing their
expenditures under the fiscal and administrative autonomy given upon the districts and cities. Thus, it is expected
that districts and cities could enhance their efforts in collection their own-source revenues. As seen in Table 3
however, Own-source revenues increased from 5,170 trillion IDR in 2001 to 20,142 trillion in 2008 with an average
increase about 10,725 trillion IDR every year during the period. This figure is quite low. In 2001, own-source
revenues were about 5,170 trillion IDR with a relatively small increase every year and reached 20,124 trillion IDR
in 2008. On average, own-source revenues were only 7.7% of the total revenues, this is still not significant. A
substantial amount of the own-source revenues is from local taxes, other revenues and proceeds from the
management of districts and cities’ assets set aside for the purpose. Although own-source revenues had risen in
nominal term every year, but the relative share of own-source revenues in total revenues is significantly low,
approximately thirteen-fold smaller than balancing funds. Other revenues which consist of incomes from grants and
emergency fund were rising from about 2,769 trillion IDR in 2001 to 12,710 trillion IDR in 2008. Revenue from
16
The taxes were categorized into Province Taxes of which there are 5 types, (1) Motorized Vehicle Tax and Above
Water Vehicles Tax; (2) Vehicle Transfer Tax and Above Water Vehicles; (3) Motored Vehicle Fuel’s Tax; (4) Tax
for Taking and Using Under Earth Water and Surface Water; and (5) Cigarette Tax.Whilst District/Municipality
taxes consist of 11 types, (1) Hotel Tax; (2) Restaurant Tax; (3) Entertainment Tax; (4) Advertisement Tax; (5)
Street Lighting Tax; (6) Tax for Mining Class C; (7) Parking Tax; (8) Ground Water Tax; (9) Swallow Tax; (10)
Rural and Urban Land and Building Tax; and (11) Acquisition fees from Building and Land (Law No. 29/2008,
Chapter II, Article 2).
grants and emergency funds remains small for the districts and cities because these revenues are considered as
untied financial assistance to districts and cities and not all local governments obtain such funds every year. Overall
contribution of other revenues to total revenues from 2001 to 2008 was about 5.5%.
Table 3. Revenue structure of district and city governments average 2001-2008 (Trillion IDR)
Own-source Balancing funds Other sources of Total

revenues revenues revenues
2001 5,170 68,671 2,769 76,610
(6.7%) (89.6%) (3.6%)
2002 7,079 74,810 4,084 85,973
(8.2%) (87%) (4.8%)
2003 8,161 89,391 8,286 105,839
(7.7%) (84.5%) (7.8%)
2004 9,219 92,379 8,787 110,385
(8.4%) (83.7%) (8.0%)
2005 9,299 92,603 8,306 110,207
(8.4%) (84%) (7.5%)
2006 9,909 135,727 7,564 153,200
(6.5%) (88.6%) (4.9%)
2007 16,824 185,782 5,171 207,778
(8.1%) (89.4%) (2.5%)
2008 20,142 231,535 12,710 264,387
(7.6%) (87.6%) (4.8%)
Average 7.7% 86.8% 5.5% 100%
Numbers in parentheses are shares to total revenues

Source: own calculation based on data from Ministry of Finance.
The share of balancing funds in total revenues of districts and cities has increased steadily with share about 86.8%
on an annual basis between 2001 and 2008 due to increasing amount of general allocation funds, revenue sharing
and special allocation funds provides to districts and cities. In the beginning of fiscal decentralisation, the balancing
funds was about 68,671 trillion IDR, this jumped more than half to about to approximately 231,535 trillion IDR in
2008. Between 2001 and 2008, balancing fund in the total revenues was 86.8% annually, meaning that the balancing
funds have been very dominant in districts and cities’ budget. In summary, there is an increase in district and city
budgets from 2001 to 2008. Nevertheless, the increase in local revenue does not necessarily imply improvement of
financing capacity of district and city governments, because the governments can only generate a small amount of
own-source revenues to finance their expenditure (see also Table 4).
The structure of districts and cities revenues addressed above suggests two important features of district and cities
city budgets: (1) strong reliance of local budget upon fiscal transfers from higher level of governments; and (2) low
revenue-raising efforts. Local governments across Indonesia are very much dependent on fiscal transfers from the
central government due to the highly centralised fiscal system in Indonesia in the past. Under the centralised fiscal
system, the central government collected the majority of the revenue across the country. For instance, in 2011, about
91% of revenue collection and 64% of direct spending is held by the central government (Shah, Qibthiyyah, & Dita,
2012, p.7).
As Lewis notes, despite fiscal decentralisation in Indonesia, local government authority over local tax administration
and collection has not changed much and can still be considered as the lowest in the world (Lewis, 2003, p.227). It is
true that fiscal decentralisation law provides legal right to district and city government to create new taxes and levies
in their jurisdiction, the fiscal system in Indonesia provides minimal fiscal autonomy to local governments in terms
of revenue assignment since the central government still retains more authority in collecting some major and
productive revenues sources such as income tax and oil revenues (see for example, Suhendra & Amir, 2006;
Taliercio, 2005, p.111). The relatively low own-source revenues at all districts and cities was due to insufficient
capacity of district and city governments and weak fiscal tools in administering and collecting local revenue sources
at local level. As stated, such conditions are largely caused by the long history of centralised revenue collection in
Indonesia (Lewis, 2003; Suhendra & Amir, 2006; Taliercio, 2005). Since fiscal decentralisation, district and city
governments have created some taxes or levies that are economically harmful to their economy activities due to
unclear, and often conflicting, objectives of the taxes and levies (Lewis, 2003, p.228). Such a condition in turn poses
profound arguments on why districts and city governments have not achieved significant revenue autonomy under
fiscal decentralisation era.
The financing capacity of district/city governments as summarised in Table 4. It indicates that districts and cities
have failed to keep pace total expenditures within their jurisdictions. As seen in the table, districts and cities
generate less own-source revenues relative to their total expenditure between 2001 and 2008. It implies that their
total expenditures are much more dependent on financial transfers from higher government levels or implies a broad
vertical imbalance between districts and city governments and the higher level of governments (both provinces and
central governments). Overall, districts/cities were only able to finance not more than 8% of their expenditures
based on their own-revenue sources. For example, in 2001, financing capacity of districts and cities was 7.4%. This
rate increased slightly until 2005, before falling to about 6.6% in 2006. Based on these figures, it is evident that
district and city governments are heavily dependent on other central government in performing their functions in the
public goods and services provision within their jurisdiction.
Table 4. Financing capacity of district and city governments (Trillion IDR)
Own-source Total Financing

revenues expenditures Capacity (%)
2001 5,170 69,431 7.4
2002 7,079 82,791 8.6
2003 8,161 101,345 8.1
2004 9,219 98,200 9.4
2005 9,299 106,426 8.7
2006 9,909 149,234 6.6
2007 16,824 228,438 7.4
2008 20,142 254,076 7.9
Average 10,725 136,243 8.0
Intergovernmental fiscal transfers to District and City Governments

As specified in the explanation in Chapter VIII of Law No. 32/2004 and in Chapter V of Law No. 33/2004, the
balancing fund consists of sources from the national budget (APBN) which are allocated by the central government
to local governments to fund the needs of the local government in implementing decentralisation. The balancing
fund originates from three sources: (1) the Revenue-Sharing Fund (Dana Bagi Hasil); (2) the General Allocation
Funds (Dana Alokasi Umum); and (3) the Special Allocation Funds (Dana Alokasi Khusus). The objectives of the
balancing fund are to: (1) address vertical fiscal imbalances between levels of government (revenue sharing and
DAU); (2) equalise regional government fiscal capacities to deliver services (DAU); (3) encourage regional
expenditure on national development priorities (DAK); (4) promote the attainment of minimum infrastructure
standards (DAK); (5) compensate for benefit/cost spillovers in priority areas (DAK); (6) stimulate regional
commitment (DAK); and (7) stimulate revenue mobilization (revenue sharing, DAU, DAK) (Sidik, 2007, pp.377-
378).
Revenue sharing is derived from taxes and natural resources. Revenue sharing from taxes is generated from land and
building tax (Pajak Bumi dan Bangunan, PBB), acquisition fees from building and land, or land rent (Bea Perolehan
atas Hak Tanah dan Bangunan, BPHTB), and personal income taxes (Pajak Penghasilan, PPh), revenue sharing from
natural resources is derived from forestry, general mining, fisheries, petroleum mining, gas mining and geothermal
mining. Revenue sharing from PBB and BPHTB17, as explained earlier, is divided between the provincial
17
PBB and BPHTB for urban and rural have been decentralised since the enactment of Law No. 28/2009 on Local
Tax and Levies.
governments, district/city governments, and the central government under the following formula. Ninety per cent
(90%) of the revenue obtained from PBB is allocated to the respective local governments with details as follows:
a) 16.2% is allocated to the province from which the fund originates,
b) 64.8% is allocated to respective districts/cities,
c) 9% is used as collection fees.
The rest of the 10% of revenue-sharing is distributed to other local governments across Indonesia under the
following rules:
a) 65% is distributed evenly to all districts/cities, and
b) 35% is distributed as incentives to certain districts/cities which had good fund-generating performance
during the previous fiscal year.
According to Law No. 32/2004, Chapter VIII, Article 161 of and Chapter VI, Article 27-29 of Law No. 33/2004, the
DAU is an unconditional grant from the central government to local governments aiming to help local governments
meet their expenditure needs in implementing decentralisation. Since local governments have differences in their
revenue-raising capacity (known as horizontal imbalances), it is likely they also have different capacities in
providing public services. Thus, DAU is allocated to correct horizontal imbalances among local governments (Sidik,
2007, p.389). Since there is no condition attached to DAU, the recipient local governments can spend DAU as they
choose (Sidik, 2007, p.377). DAU is calculated based on certain criteria emphasising aspects of equity and justice in
harmony. The total amount of the DAU shall be at least 26% of the net domestic revenues as reflected in APBN.
The DAU should be allocated based on the existing fiscal gap and the basic allocation. Fiscal gap is calculated as the
fiscal need less fiscal capacity of the region; the basic allocation, however, should be calculated from the total
salaries of the civil servants in the region.
Under decentralisation, all local governments have full autonomy and discretion to allocate funds obtained from the
DAU. In addition to DAU, the central government also allocates DAK to local governments. The DAK fund is
allocated to finance specific activities in the region that are part of the national priorities and to finance special
activities proposed by the region (Law No. 32/2004, Chapter VIII, Article 162). According to Law No. 33/2004, the
purpose of the DAK fund includes helping to fund important needs which cannot be estimated in the DAU formula,
and to assist with funding expenditures related to national priorities or commitments (Sidik, 2007, p.407). According
to Law No. 33/2004, DAK is considered to be a matching grant which means the recipient local governments are
required to provide at least 10% contributory funding from their own budgets to the overall amount of DAK given to
the region (Chapter VI, Article 41). The contribution funding to DAK required from the local governments aims to
establish local government ownership of, and participation in, decisions concerning investments. In addition, the
contribution fund is also to encourage the local government to pay attention to local benefits and financial valuations
in investment selection and design (Sidik, 2007, p.410).
As mentioned before, under fiscal decentralisation policy, central government assigns functions and responsibilities
to local governments. Whether or not local governments can financed the assigned functions by their own-revenue
sources is a significant matter. As shown in earlier section, own-source revenues in all districts and cities are very
small which implies that their own revenue cannot cover their expenditures. This is called a mismatch between
revenue capacity and expenditure responsibilities. To mitigate the mismatch, local governments must seek revenue
sources outside their own source, mostly from higher government levels in form of fiscal transfers, either from
central or provincial governments. The dependency of local revenue on fiscal transfers from higher government
level is known as vertical imbalances (Bahl & Wallace, 2007; Bird, 2010).
Table 5 presents details of total balancing funds which compose of revenue sharing, general allocation funds and
specific allocation funds between 2001 and 2008. In principle, districts and city government have discretionary
power in the allocation of revenue sharing and general allocation funds, while specific allocation funds are
considered as tied funds for which districts and cities have to spend the funds on specific sectors determined by the
central government. During this period, total balancing funds have increased steadily from about 68,671 trillion IDR
in 2001 to approximately 121,362 trillion IDR in 2008. As be seen in Table 5, a substantial proportion of balancing
fund transfers were general allocation funds, dominating balancing funds to districts and cities with average about
74.9% per year between 2001 and 2008. As stated earlier, general allocation funds are provided as an equalisation
funds to local governments. Thus, districts and cites which have a relatively low own-source revenues will receive
bigger share of general allocation funds. General allocation funds percentages were followed by revenue sharing and
specific allocation funds which were approximately 20.4% and 4.6% of central government expenditures per year,
respectively.
General allocation funds are spent largely to pay wages and salaries of the government employees and also other
bureaucratic and administration cost. Compared to period of the early decentralisation in 2001, specific allocations
funds have increased significantly since 2003. Such increase was due to the increase of the national priorities18
funded with the specific allocation funds. Prior to 2005, specific allocations fund was aimed to finance education
sector, health, road, irrigation, government infrastructure, marine and fisheries. After 2005, new sectors had been
added to the national priority sectors to be financed by the Specific Allocation Funds. These sectors are clean water
and agriculture which were added to the list in 2005, environment sector was added in 2006, family planning and
forestry in 2008, and trade and infrastructure of rural areas were listed in the national priorities in 2009
(Decentralisation Support Facility, 2011).
Despite the substantial balancing funds given to districts and cities, the balancing funds are not directly linked to the
improvement in local development because majority of the funds are largely spent to cover routine/current
expenditure such as salaries and wages (see Figure 8 for comparison on capital and routine/current expenditures). In
addition, the dominance share of the balancing funds in district and city governments’ revenue in Indonesia indicates
an excessive reliance of the local governments on fiscal transfers. When compared to many developing countries in
around the world, it is seen that fiscal transfers to local government covers about 60% of their expenditures, while in
more developed countries such as OECD countries, fiscal transfers accounted to about 29% of the local
governments’ expenditures in the Nordic countries and about 46% non-Nordic Europe (Shah, 2007).
Table 5. Balancing funds to district and city governments, (Trillion IDR)

Revenue General Specific Total
Sharing Allocation Allocation Funds
Funds
2001 13,864.53 53,973.11 833.52 68,671
(20.2%) (78.6%) (1.2%)
2002 15,900.92 58,362.72 546.25 74,810
(21.3%) (78.0%) (0.7%)
2003 19,345.34 66,891.50 3,154.55 89,391
(21.6%) (74.8%) (3.5%)
2004 21,577.56 67,989.01 2,812.22 92,379
(23.4%) (73.6%) (3.0%)
2005 16,914.02 71,868.27 3,820.53 92,603
(18.3%) (77.6%) (4.1%)
2006 20,231.37 106,209.94 9,285.76 135,727
(14.9%) (78.3%) (6.8%)
2007 38,394.36 131,213.40 16,174.63 185,782
(20.7%) (70.6%) (8.7%)
2008 53,531.81 157,452.51 20,550.56 231,535
(23.1%) (68.0%) (8.9%)
Average 24,969.99 89,245.06 7,147.25 121,362
(20.4%) (74.9%) (4.6%)
Numbers in parentheses are shares to total revenues
The Revenue and Expenditure Provincial Governments

Table 6 presents the total revenues19 of provinces grouped into five major islands: Sumatera (10 provinces); Jawa
and Bali (7 provinces); Kalimantan (4 provinces); Sulawesi (6 provinces); Nusa Tenggara, Maluku and Papua (6
provinces). This grouping shows that there are considerable disparities across islands. It can be seen that provinces
in Jawa and Bali have the highest total revenue relative to GDRP among provinces. On average, the total revenue in
18
The national priorities are stipulated in Article 39, Law No. 33 of 2004 which are further explained in Article 51,
Government Regulation No 55 of 2005.
19
Total revenues compose own-source revenue, balancing funds, and other incomes. Other incomes for provinces are excluded
from analysis because not all provinces have generated such incomes during the considered period. Recall that total revenue size
of government is calculated as total revenues as a percentage of GDRP in each respective year.
Jawa and Bali Islands accounted to 22.5% between 2001 and 2010. Provinces in Jawa and Bali have also recorded
the highest percentage of revenue measured as own-source revenues as a percentage of GDRP with an average about
13.5%, this rate is eight-fold larger than the size of own-revenue sources in all other provinces. The magnitude of
the total revenue size and own-source revenues size above of provinces in Jawa and Bali indicates that those
provinces are in a better position in term of revenue collections under fiscal decentralisation arrangement. Higher
revenue size of provinces in these islands was due to the fact that economic development in the provinces is largely
driven by secondary and tertiary economic activities such as manufacturing industry and services20. Provinces in
Nusa Tenggara, Maluku and Papua are next in terms of the total revenue size of government, with an average at
13.2% in 2001-2010. Total revenue in these islands is largely a result of the substantial amount of balancing funds
given to those provinces. As seen in Column 4, Table 6, provinces in Nusa Tenggara, Maluku, and Papua recorded
the highest revenue size of government in term of the amount of balancing funds that they received from the central
government, about 9.1% during 2001-2010. In the same period, provinces in these islands are not superior in own-
source revenues generation as seen in Column 3, own-revenue in Nusa Tenggara, Maluku and Papua has been the
lowest amongst provinces, only about 1.4%.
Table 6. Total revenue size of provincial government for main Islands average 2001-2010
Island Total revenue Own-source Balancing funds

as % of GDRP revenues as % of as % of GDRP
GDRP
Sumatera 4.9 1.6 2.9
Western
Jawa & Bali 22.5 13.5 8.4
Middle
Sulawesi 7.5 1.7 5.5
Eastern
Nusa Tenggara,
13.2 1.4 9.1
Maluku & Papua
Figure 6 shows provinces ranked by the total revenue relative to GDRP between 2001 and 2010. As seen, after nine
years of fiscal decentralisation, there is an upward trend of the total revenue in all provinces with overall size was
6.2% annually during 2001-2010. In the early of fiscal decentralisation, in average, total revenue size of provinces
stood at 2.6% of GDRP and increased slightly to 3.6% in 2002. A marginal increase in the total revenue size
continued in 2003-2004 with an average at 4.3% and 4.8% respectively and become 5.1% in 2005. The total revenue
size continued to rise with average of 9.4% in2009, before declining back to 8.9% in 2010.
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20
While economic activities in most provinces in other islands are very dependent on natural-resources-related sectors such as
agriculture, forestry and mining.
Figure 12. Provinces in Indonesia ranked by total revenue size average 2001-2010
All Provinces
2001: 2.6%
2002: 3.6%
2003: 4.3%
2004: 4.8%
2005: 5.1%
2006: 7.1%
2007: 7.9%
2008: 8.4%
2009: 9.4%
2010: 8.9%
Note: Revenue size for Kepulauan Riau, Sulawesi Barat and Papua Barat is an average from 2004-2010.
As displayed in figure above, provinces which have higher total revenue are located in eastern part of Indonesia.
Papua Barat d had the highest total revenue as percentage of GDRP with an average size is 19.2% from 2001 to
2010. This was followed by Papua, Maluku and Gorontalo with average at 16.6%, 15.8% and 15.5% respectively.
Whereas Jawa Barat and Jawa Timur that are in western part of Indonesia recorded the lowest average rates of 1.9%
and 1.8% respectively. The trend above shows some interesting facts. Five provinces that recorded the highest total
revenues as percentage of GDRP are located in the eastern part of Indonesia. Of five provinces, three are new
provinces which were established and split off from their “parent” province since the decentralisation era. These are
Papua Barat which split off from Papua in 2003, Maluku Utara which was originally part of Maluku before 1999
and Gorontalo that split off from Sulawesi Utara in 2000. This indicates that fiscal decentralisation has substantially
increased the total revenue as percentage of GDRP of new provinces in Indonesia. By contrast, five provinces which
recorded the lowest total revenues as percentage of GDRP are located in Java and Sumatera that is in the western
part of Indonesia. It is important to understand that the higher revenue size does not simply indicate a favourable
financial performance; it was largely driven by revenue received from the central government in the form of
intergovernmental transfers or balancing funds, as shown in greater detail below.
Figure 13 shows revenue of government is estimated as own-source revenues as a percentage of GDRP. As
displayed in the figure, locally raised revenue in all provinces is abysmally low ranging from a low of 0.6% in 2001
to a high of 2.7% in 20010 with an average was only about 1.6% every year. Own-source revenues comprised only
0.9 1% of GDRP in the beginning of fiscal decentralisation and 0.9% in 2002. It had a steady position with an
average size above 1% of GDRP but still less than 2% between 2003 and 2006. Own-source revenues rose to about
2% in 2007 and increased further to about 2.7% by 2010. Variation of own-source revenue is quite different than the
total revenue as shown in Figure 6. When compared individually, the spatial distribution of the size of own-source
revenue does not skew to particular islands. As seen in Figure 13 below, five provinces which have higher of own-
source revenues are distributed across different islands ranging from middle part of Indonesia (Bali, 3%), western
island (Bengkulu, 2.6%; Jambi and DKI Jakarta, 2.5%) and eastern island (Gorontalo, 2.4%). Across provinces, the
lowest size of own-source revenues was in Papua Barat which was only 0.6% between 2001 and 2010. The lowest
size of own-source revenues of this province could possibly due to its status a newly established province and its
location is in the most remote area in Indonesia.
Figure 13. Provinces in Indonesia ranked by size of own-source revenues, average 2001-2010
All Provinces
2001: 0.6%
2002: 0.9%
2003: 1.1%
2004: 1.4%
2005: 1.6%
2006: 1.8%
2007: 2.0%
2008: 2.0%
2009: 2.3%
2010: 2.7%
Figure 14 shows the revenue calculated from balancing funds as a proportion of GDRP. In 2001, the size of
balancing funds was about 1.6 and reached 6.1% in 2010 with an average rate of 3.9% GDRP during the time. As in
the figure, there was a small increase of the size of balancing funds from 2002 until 2005 with an average rates
across provinces were approximately 2.6% in 2002, 2.7% in 2003, and 2.8% and 2.9% in 2004 and 2005. Between
2006 and 2007, the size of balancing funds increased from 4.6% to 4.7%, while during the period 2008-2009, the
size was unchanged at about 5.5% for all provinces in Indonesia. Spatial variation of the size of balancing funds
among provinces as shown in Figure 8 confirms that some new provinces and their parent provinces located in the
eastern part of Indonesia had the largest balancing funds. These provinces are Maluku Utara which posted 14.8% of
balancing funds as a percentage of its GDRP between 2001 and 2010, Papua Barat (14.6%), Gorontalo (12.4%),
Maluku (12.1%), Sulawesi Barat (8.4) and Papua (6%). On the other end of the scale, provinces in the western part
of Indonesia such as Jawa Timur, Jawa Barat, and Sumatera Utara showed the lowest size balancing funds which an
average size less than 1% from 2001 to 2010.
Next page
Figure 14. Provinces in Indonesia ranked by the size of balancing funds, average 2001-2010
All Provinces
2001: 1.6%
2002: 2.6%
2003: 2.7%
2004: 2.8%
2005: 2.9%
2006: 4.6%
2007: 4.7%
2008: 5.5%
2009: 5.5%
2010: 6.1%
The total expenditure as percentage of GDRP of all provinces from 2001 to 2010 is presented in Table 7. As seen in
the table, there is no significantly difference across provinces in all islands based on their total expenditure.
Provinces in Sumatera Island made the highest total expenditures size with an average rate of 4%. While provinces
in Kalimantan Island, Sulawesi, Nusa Tenggara, Maluku and Papua Islands had a slightly similar expenditure size
with averages range from 3.6% and 3.4% respectively. In contrast, provinces in Jawa and Bali Islands recorded the
lowest total expenditure relative to GDRP which accounted only about 2.5%.
Table 7. Total expenditure as percentage of GDRP of provincial government for main Islands*
Island Total Capital expenditure Current expenditure

expenditure as % of GDRP as % of GDRP
as % of GDRP
Sumatera 4.0 2.4 1.6
Western
Jawa & Bali 2.5 1.6 0.9

Middle
Sulawesi 3.4 2.1 1.3

Easter
Nusa Tenggara,
3.4 2.1 1.3
n
Maluku & Papua
* average 2001-2010
Figure 16 below shows spatial variability of the total expenditure size as percentage of GDRP of all provinces. As
seen, the total expenditure of all provinces has been rising since the introduction of fiscal decentralisation. On
average, it increased from 2.9% in 2001 to a peak of 10.2% in 2010, before falling back to about 5.9% in 2010. Five
provinces which have higher total expenditure size are Maluku Utara (20.4%), Papua Barat (17.7%), Sulawesi Barat
(14.4%), Papua (14.2%) and Maluku (13.6%). While provinces which have smaller size of expenditure are in
Sumatera and Jawa Islands such as Jawa Barat and Jawa Timur (1.3%), Sumatera Utara (1.5%), Jawa Tengah (1.7)
and Banten (1.9%). The skew of the expenditure size of government as in the figure below is makes sense in the
light of the higher total revenue size in those provinces as explained earlier.
Figure 16. Provinces in Indonesia ranked by total expenditures as percentage of GDRP, average 2001-2010
All Provinces
2001: 2.9%
2002: 3.2%
2003: 3.7%
2004: 3.3%
2005: 5.7%
2006: 4.6%
2007: 6.0%
2008: 9.0%
2009: 10.2%
2010: 5.9%
As indicated, capital expenditure and current expenditures of local government pinpoints the key priorities areas of
development of the local governments. Capital expenditure can be categorised as expenditure on assets which
consists of land expenditures, building expenditure, and other fixed asset expenditures. While current (routine or
operating) expenditure are recurring expenditures which includes wages and salaries expenditures, materials, interest
payments, subsidies, grants and social assistance. As shown in Figure 17, capital expenditure across the province
fluctuated between 2001 and 2010. In early fiscal decentralisation, all provinces made up only about 1.5% of capital
expenditures relative to GDRP and this increased slightly to 1.7% in 2002. A modest increase of capital expenditure
was seen during 2003-2004 with average rates in all provinces equivalent to 2.1% and 2.4% of GDRP by annual
basis. The size of capital expenditure has increased further from 2005 and reached about 5.6% of GDRP in 2009
before decreasing to 2.8% in 2010. During that period, the size of capital expenditures ranged from 0.7% (the
lowest) in Jawa Timur and 12.8% in Maluku Utara (the highest). As indicated, provinces in eastern part of
Indonesia, especially Maluku Utara, Sulawesi Barat, Papua Barat, Papua and Gorontalo had higher capital
expenditure as percentages of GDRP due to increasing infrastructure development in these provinces.
Figure 17. Provinces in Indonesia ranked by capital expenditures as percentage of GDRP, average 2001-2010
All Provinces
2001: 1.5%
2002: 1.7%
2003: 2.1%
2004: 2.4%
2005: 4.5%
2006: 3.2%
2007: 4.0%
2008: 5.2%
2009: 5.6%
2010: 2.8%
Similar to the size of capital expenditure of provincial government, size of current expenditure also show a modest
increase from 1.3% in 2001 to about 2.8% (Figure 18). Accordingly, Papua Barat registered the highest size of
current expenditure with an average at 8.4% of GDRP from 2001 to 2008. Higher size of current expenditure is also
appeared in Maluku Utara (7.6%), Maluku (7%) and Papua (5.3%). Current expenditure was fairly low in Jawa
Tengah and Jawa Barat which represented only 0.4% of GDRP. Based on analysis on the size of capital expenditure
and current expenditure as percentage of GDRP above, it can be concluded that the expenditure size of provincial
government in Indonesia is considerably small with an average less 4.5% on annual basis21.
21
Research on the optimum size of expenditure of government is very limited which leads to an absence of the
theoretical and empirical agreements on the optimum level of the size of expenditure of government. As for
comparison, Chobanov and Mladenova (2009) found that the optimum size of government in OECD countries is no
more than 25% of GDP. Using a normal distribution to determine the optimum size of government measured as
public expenditure as a percentage of GDP, Ekinci (2011) suggested that the minimum level of expenditure as a
percentage of GDP should be at 4.55%, while the optimum level at 13.4% which was the case in some developed
countries such as UK, USA and the European countries, the optimum expenditure size of government was
approximately 13.4%, while the maximum expenditure as a percentage of GDP should be no while the maximum
expenditure as a percentage of GDP should be no greater than 31.7%. Based on data of 23 OECD countries, Witte
and Moesen (2010) claimed that the optimum size of government is at 41.22 % of GDP.
Figure 18. Provinces in Indonesia ranked by current expenditures as percentage of GDRP, average 2001-2010
All Provinces
2001: 1.3%
2002: 1.5%
2003: 1.6%
2004: 1.0%
2005: 1.3%
2006: 1.5%
2007: 2.0%
2008: 3.8%
2009: 4.6%
2010: 2.8%
Revenue Decentralisation and Financing Capacity of Provincial Level

Provincial government’s total revenues consist of own-source revenues, balancing funds; and other sources of
revenue22. In reality, provincial governments cannot make the most of their capacity to optimize their revenues from
own-source revenues. In 2001-2002, total balancing funds was about 62.5% and 62.9% of the total provincial
revenue respectively. At the same period, own-source revenues made between 27.3% and 34.7% of total revenues.
For three years between 2003 and 2005, the proportion of the balancing funds in provincial revenue was slightly
decreased to 57%, 55.2% and 52.3% respectively. Provincial governments continued to receive a significant amount
of balancing funds in between 2006 and 2010 with steady contribution from 2006 to 2010 with proportion less than
40% of total revenues, but it made 41.9% of the total revenues composition in 2005. The dominant proportion of
balancing funds in provincial revenue indicate clearly that balancing funds, which were merely supposed to be
subsidiary funds to local budgets, has functioned as one of the main sources of revenues of provincial governments
which may also has substitute the function of provincial’s own revenues to finance provincial expenditures. Overall,
balancing funds from national level to provinces constituted more than half of total provincial budgets with
proportion to total revenues about 57% from 2001 to 2010 (Figure 19). Own-source revenue contributed about 37%
and other revenues made up only about 5% of the provincial revenues at the same period.
22
Other sources of revenues include grant, emergency fund and other income. But in general, such revenues are
significantly smaller than own-source revenues and also balancing funds.
Figure 19. Structure of provincial revenue, average, 2001-2010
Other source of revenues, 5%
Balancing funds, 57%
Own-source revenue, 37%
The higher proportion of balancing funds indicates that provinces are more dependent upon intergovernmental
transfers, hence revenue sharing from tax and non-tax, general allocation funds and also specific allocation funds. It
implies that provincial governments also had not been able to increase their revenue raising power as deliberately
designed under fiscal decentralisation. As stated previously, the dependency of provincial budgets upon balancing
funds from central government could be as the result of a very long period of centralised revenue collection by the
central government in Indonesia. As a result, the fiscal decentralisation policy which ideally provides opportunities
and encourages local governments to become financially independent from fiscal transfers has not led to significant
change. Lack of financial capacity and the past centralised revenue collection system have contributed to the fiscal
dependency of local governments on transfers from central government. This is shown by a large vertical fiscal gap
which is compensated with balancing funds from central government to local government, including provinces as
shown in Table 8.
Table 8. The structure of provincial revenues, average 2001-2010 (%)
Own-source revenues Balancing Other source of

funds revenues
2001 27.3 62.5 10.1
2002 34.7 62.9 2.3
2003 36.3 57.0 6.7
2004 38.8 55.2 6.0
2005 41.9 52.3 5.8
2006 36.3 60.1 3.6
2007 37.5 55.1 7.4
2008 37.6 57.8 4.6
2009 38.2 55.0 6.9
2010 39.1 59.7 1.1
Spatial variation in the own-source revenues generation across provinces in presented in Figure 20. This reveals a
significant difference in the revenue raising power among provinces in different islands, especially between western
part of Indonesia and eastern part of Indonesia23. Provinces such as Jawa Barat, Jawa Timur, Jawa Tengah and
Sumatera Utara are the most developed provinces in Indonesia. In these provinces, economic development is
significantly higher than other provinces which contribute to the higher GDRP and economic development and
eventually will contribute to higher local revenues. As shown, five provinces which had greater proportion of own-
source revenues in their total revenues are located in Jawa Island (Jawa Timur, Jawa Tengah, Jawa Barat, and
Banten) and Sumatera Island (Sumatera Utara).
Among 33 provinces, on average, Jawa Barat and Jawa Timur had the highest own-source revenues in the total
revenue which accounted almost 70% between 2001 and 2010. Sumatera Utara and Banten also had considerable
performance of revenue power where 65% and 64% of their total revenue came from own-source revenues
respectively. Some important factors which could explain the difference in the provincial capacity in revenue
making locally are the wide gap in fiscal resources and poverty rate among provinces across Indonesia. As found by
the World Bank (2009), regions which have higher fiscal resources and lower rate of poverty as well as high GDRP
tend to have higher own-source revenues than regions with lower fiscal resources and higher poverty rate. By
contrast, regions with higher poverty and lower GDRP have less own-source revenues and higher dependency upon
balancing funds from central government. These provinces include Papua Barat, Papua and Maluku Utara which
collected own-source revenues less than 9% every year between 2001 and 2010.
Figure 20. Revenue decentralisation*, average 2001-2010 (%)
* calculated as own-source revenues as % of total revenue.

23
This finding supports view of the regional inequality of economic development between Jawa Island and outside
Jawa (particularly eastern part of Indonesia). About 80% of the Indonesian economy is occurred in the provinces in
these islands, while other provinces only made small contribution to Indonesian economy (Kuncoro, 2013).
As explained earlier, under fiscal decentralisation policy, central government provides balancing funds to local
governments in order to create financing balancing between central and local governments (provinces and
districts/cities), and also amongst local governments. The balancing funds comprise general allocation funds,
specific allocation funds and revenue sharing funds. Specifically, general allocation funds aim to finance
administrative and other costs associated with new functions performed by local governments under the
decentralisation policy. This fund includes financing wages and salaries as a basic allocation24, while the specific
allocation grants aim to finance development sectors identified as national priorities (Shah, Qibthiyyah, & Dita,
2012). On the other hand, revenue sharing was developed to meet aspiration from the local level to have more access
and control over local revenues, to stimulate mobilisation of revenue at local level and also to equalise fiscal
imbalances (Sidik & Kadjatmiko, 2002).
As shown in Table 9, general allocation funds constitute the biggest proportion of total balancing funds with an
average about 64.9% between 2001 and 2010. This is followed by revenue sharing funds of approximately 32.9%
and special allocation funds about 2.2% between 2001 and 2010. Between 2001 and 2003, general allocation funds
made up about 67% of the balancing funds before declining to around 65.3% and 59.8% in 2004 and 2005
respectively. The amount of general allocation funds being transferred to provincial governments continued to
increase in 2006 to a peak of 70.6% in 2007, falling to about 65.2% and 55.8% in 2008-2009 and to 55.8% in 2010.
The higher proportion of general allocation funds in the provinces’ revenue indicates that provinces are not yet
financially independent. Rather, the provinces remain heavily dependent to the central government as more than half
of their revenue came from general allocation funds. Based on these facts, it could be argued that providing the
funds to local level which was meant to overcome either vertical or horizontal fiscal imbalances among government
tiers has failed.
Some criticisms have emerged of the general allocation funds being transferred to local governments. One criterion
in determining the amount of general allocation funds is the level of own-source revenues of each local government.
Provinces which have higher own-source revenues will receive small general allocation funds, by contrast, province
that have lower own-source revenues will receive bigger amount of general allocation funds. This approach creates
disincentives to provinces to raise their own-source revenues since an increase in own-source revenues is offset by
decrease in general allocation funds composition (Shah, Qibthiyyah, & Dita, 2012, p.7)25. In addition, the general
allocation funds to provinces have been used largely to finance wage and salaries of civil service while only a small
portion has been allocated as financial equalisation among local governments26. As the result, the local governments
spend less on capital and infrastructure spending that can promote local development (OECD, 2012;
Decentralisation Support Facility, 2011). Hence, the aims of the general allocation fund to reduce regional
imbalances and regional disparity in development have not been achieved. If this practice continues in the future, it
is anticipated that local governments will still be highly reliant upon transfers from central government and the
regional disparity, especially between rich regions and poor regions will continue to worsen.
Prior to the implementation of fiscal decentralisation, the central government enjoyed more taxes and natural
resources revenues collected from provinces in Indonesia. This was due to a centralised revenue collection, while
provincial and district/city government had less opportunity to collect taxes in their regions (Shah, 2012, Shah,
Qibthiyyah, & Dita, 2012). Since the fiscal decentralisation law was imposed, one of the key issues of the local
budget has been the financing capacity of local governments; whether they could finance their own expenditure
responsibilities from their own revenue sources, financing capacity. The extent of the financing capacity of
24
Basic allocation is to be used to finance wage and salary of the government employees. This arrangement is made due to significant transfers of
government employees from central government to provinces, districts and cities since the decentralisation era. Salary and wage of such
employees are mostly paid by the general allocation funds under the basic allowance formula. The basic allocation in general allocation fund was
actually relative similar with the scheme of subsidy to autonomous regions (Subsidi Daerah Otonom) which given to local government to finance
wage and salaries prior to decentralisation in 2001. In addition to SDO, local government also received Dana funding from central government
under President Instruction which so-called Dana Inpres which used to finance some development sectors such as education, health and
infrastructure with local jurisdictions.
25
Under the current formula, actual revenues are used as opposed to potential revenues to calculate the own-source revenues of each local
government in general allocation funds formula. This technique has created disincentive to local governments in improving their own revenue
collection locally because any increase in taxes collection that lead increase of own-source revenues will offset by decrease in general funds
entitlements to be received (Shah, Qibthiyyah, & Dita, 2012, p.9).
26
Local governments may be very reluctant to develop efficiency in their administration, for example by tighten personnel size due to the basic
allowance which they receive in general allocation funds. As analysed by Fadliya & McLeod (2010) local governments do not have willingness
to reduce or avoid the number of their personnel as any reduction in the personnel costs such as wage and salaries will be offset by an equal
reduction in the general allocation funds.
provincial governments is well above that of district and city governments. In the early days of fiscal
decentralisation the total expenditures of provincial governments was 23.9 trillion IDR, and their own-source
revenue was only 9.9 trillion IDR. Hence own-source revenue covered only about 41.5% of the provincial
expenditures. The financing capacity of provincial governments increased over the following years and peaked in
2009.
Table 9. Financing capacity of provincial governments (Trillion IDR)
Own-source Total Financing

revenues expenditures Capacity (%)
2001 9,941 23,968 41.5
2002 14,232 30,652 46.4
2003 17,727 33,545 52.8
2004 22,576 32,034 70.5
2005 27,905 57,243 48.7
2006 30,553 47,037 65.0
2007 35,108 63,256 55.5
2008 37,277 76,934 48.5
2009 42,507 105,595 40.3
2010 56,267 51,364 109.5
Average 29,409 52,163 57.9
Intergovernmental fiscal transfers to Provincial Governments

Under fiscal decentralisation, local governments, especially those producing regions, are receiving higher amounts
of taxes and natural resources revenues. According to fiscal decentralisation law, local governments will receive
shares of revenues from taxes and natural resources which collected by the central government from their
jurisdiction disproportionally where producing regions receive higher amount of the revenue collected. As a result of
this arrangement, natural-resources rich regions, which are mostly located in Kalimantan Timur, Papua and Riau,
will gain substantial amount of revenue sharing. Taxes shared consist of property tax (land and building tax, or PBB,
acquisition rights to land and buildings tax (BPHTB) and personal income tax, while natural resources revenue
comes from forestry, fishery oil, gas, and general mining. As indicated in Table 10, revenue sharing between the
central and provincial government is also considered as an important component of balancing funds ranging from
27.7% and 40.4% with an average about 32.9% annually between 2001 and 2010.
Revenue sharing fluctuated from 2001 to 2010. In 2001, revenue sharing was about 31.7% of the balancing funds,
falling to 29.5% in 2002 before increasing back to about 31.2% and 34.5% in 2003 and 2004 respectively. In 2005,
the revenue sharing increased significantly to about 40% of the balancing funds due to increase in the oil price since
revenue sharing from oil provides the biggest contribution to revenue sharing from natural resources. Revenue
sharing funds decreased to about 32.7% in 2006, 27.7% in 2007, and 29.9% in 2008 before increasing to 31.4% and
40.4% of the total balancing funds in 2009 and 2010. This increase was due to the increase in the land and building
tax sharing and also increase in the general mining sharing during that period (Francis, 2012). Specific allocation
grants made the least proportion of the balancing funds accounted to about 2.2% every year during 2001 to 2010.
The amount of specific allocation funds was relatively until 2007. During that period, the specific allocations fund
can only be used to finance education sector, health, road, irrigation, government infrastructure, marine and
fisheries. Since 2008, the specific allocation fund had considerably increased due to the increase of the areas of
development under the national priorities27 that can be funded with the Specific Allocation Fund. In 2008, the new
sector that can be funded with specific allocation funds were family planning, forestry and trade, while in 2009,
27
The national priorities are stipulated on Article 39, Law No. 33 of 2004 which further are explained on Article 51,
Government Regulation No 55 of 2005.
infrastructure of rural areas were also added (Decentralisation Support Facility, 2011). Although specific allocation
funds transferred to provinces were significantly lower than the general allocation funds, the specific allocation
funds have been more effective than the general allocation fund in boosting capital spending at local government
level (Lewis, 2013). Between 2003 and 2009, every additional rupiah of the special allocation given to local
government created approximately 1.20 rupiah of capital expenditure, while an additional rupiah in general
allocation funds only stimulate about 0.09 rupiah increase in the capital spending at local level (Lewis, 2013, p.9).
Table 10. Composition of balancing funds at provincial level, average 2001-2010 (%)
General Specific Revenue
Allocation Fund Allocation Fund Sharing Funds
2001 67.3 1.0 31.7
2002 67.0 3.5 29.5
2003 67.1 1.7 31.2
2004 65.3 0.2 34.5
2005 59.8 0.1 40.0
2006 67.2 0.1 32.7
2007 70.6 1.7 27.7
2008 65.2 4.9 29.9
2009 63.4 5.2 31.4
2010 55.8 3.8 40.4
The following discussion addresses the dynamic of revenue sharing and general allocation funds across provinces in
Indonesia. Specific allocation funds are excluded from the analysis as most local governments only began to receive
the specific allocation funds by 2009. Due to the disproportionate arrangement of the revenue sharing, it is
anticipated that natural-resources rich provinces will gain more benefit from revenue sharing shown by the
proportion of revenue sharing in their balancing funds. As seen in Figure 21, it is evident that natural resources rich
provinces, except for DKI Jakarta, have gained substantial amount of revenue sharing. Five provinces on the top of
revenue sharing proportion include Riau, Kalimantan Timur, Nanggore Aceh Darussalam and Kepulauan Riau
which split off from Riau in 2004.
Riau, which has abundant oil and gas resources and contributes substantial amount of the oil and gas output in
Indonesia, has the highest proportion of revenue sharing with approximately 92% of its balancing funds coming
from the revenue sharing during 2001 and 2010. Another province which obtained huge revenue sharing is
Kalimantan Timur. As one of the major producers of oil and gas in Indonesia, Kalimantan Timur recorded about
91% of revenue sharing between 2001 and 2010.In the next place was DKI Jakarta where about 89% of the
balancing funds received by the province were from revenue sharing. Between 2001 and 2010, DKI Jakarta received
significant amount of revenue sharing from taxes. As a centre of economy activity and development and also a very
densely populated area, DKI Jakarta is one of the provinces which grow faster than the national average growth
(Kuncoro, 2013). As such, it has been able to collect substantial revenues from various taxes in its jurisdiction;
hence, one can say that DKI Jakarta is an income tax-rich province. Nanggroe Aceh Darussalam and Kepulauan
Riau also obtained significant revenue sharing from oil and gas which more than 70% of their balancing funds from
2001 and 2010. By contrast, natural-resources poor provinces which are mostly located in the eastern islands of
Indonesia have gained no more than 10% revenue sharing every year from 2001 and 2010. Of five provinces with
the least revenue sharing, four are located in eastern of Indonesia including Gorontalo (4%), Sulawesi Tengah (8%),
Nusa Tenggara Timur (9%) and Sulawesi Utara (10%). Bengkulu was the only province in Sumatera that received
an abysmally low revenue sharing.
Figure 21. Provinces in Indonesia ranked by revenue sharing as a percentage of respective balancing funds*
* average, 2001-2010
As discussed earlier, one fiscal issue of the implementation of fiscal decentralisation in Indonesia is the higher
dependency of most local governments’ budget on intergovernmental fiscal transfer from the central government.
Rich regions had benefited from the revenue sharing arrangement, while poor regions have not been able to
maximise local revenue sources. Figure 22 shows that provinces which had smaller revenue sharing in their
balancing funds indeed received larger amount of general allocation funds. Gorontalo and Bengkulu which received
the lowest general allocation funds from 2001 to 2010 were the top recipients of general allocation funds which
constituted more than 90% of the balancing funds at the same period. Sulawesi Tengah, Nusa Tenggara Timur and
Sulawesi Utara had more 80% of their balancing funds from general allocation funds.
Provinces which received higher revenue sharing will receive less general allocation funds, vice versa, is partly due
to the fiscal gap approach used on the intergovernmental fiscal transfers in Indonesia. The fiscal gap approach
determines the amount of general allocation funds given to particular local government by calculating the fiscal
capacity (own-source revenues and revenue sharing) and fiscal need (number of population, size area, construction
price index, GDRP, and Human Development Index) in each respective local government (Law No. 33/2004, Article
28).Based on the fiscal gap approach, the general allocation funds received by province will vary depending on the
size of fiscal needs and fiscal capacity. If fiscal capacity is larger than its fiscal needs in one province, then the
province will receive zero general allocation funds. This implies that higher fiscal needs compared to fiscal capacity
will be offset by a higher general allocation funds.
Despite the new arrangement on the balancing funds under fiscal desentralisation policy which meant as one of
policies to achieve fiscal equalization, horizontal and vertical imbalances seem to be an issue across local
governments in Indonesia. This could be explained with some reasons. First, the formula in determining the
balancing funds was simply based on fiscal gap approach. Under the formula, there would be an asymmetric or an
opposite direction in the amount of two major sources of balancing funds: revenue sharing and general allocation
funds. As shown by an algebraic analysis of balancing funds in Fadliya and McLeod (2010), any amount of
balancing funds received as revenue sharing is deducted from the general allocation funds entitlement to be
tranferred to each local governments. Therefore, natural-rich resources local governments which receive higher
share of revenue sharing from natural resources revenue collected within their regions are able to cover their basic
allowance (wage and salaries). As a result, the larger revenue sharing received by the rich regions is offset by
reduction in their general allocation entitlements. Second, rather to use the balancing fund, especially the general
allocation funds, to reduce the fiscal imbalances across local governments, the general allocation funds as the major
component of the balancing funds are largely allocated to finance routine expenditure such as wage and salaries.
This could exacerbate fiscal imbalances and regional disparities across Indonesia in the future.
Figure 22. Provinces in Indonesia ranked by general allocation funds as a percentage of balancing funds*
* average, 2001-2010
Concluding Remarks: Sustainability and Local Development under Fiscal Decentralisation

The practice of decentralisation in Indonesia has shown that various reforms have affected the arrangements of
authority and financial responsibility between the central government, and the local governments (province and
district/city). One objective of such fiscal decentralistion is to improve fiscal capacity of local government by raising
own-source revenues thus increase the financing capacity of local governments. However, the study on practice of
fiscal decentralization in Indonesia has not indicated an improvement on the public financing capacity of local
governments. Results from local budget analysis show that a higher proportion of balancing funds in the total
revenue of local governments indicating that local governments are largely financed by fiscal transfers from higher
government levels. As such, one can argue that local governments fail to increase revenue locally and mobilise local
economy on their own resources. Although there are increasing trends on total local government revenues, but such
increase does not necessarily imply improvement of financing capacity of local governments, because the local
governments can only generate a small amount of own-source revenue to finance their expenditure. Local budgets
rely heavily on balancing funds from central government, the balancing funds are not directly linked to the
improvement in local development because majority of the funds are largely spent to cover routine/current
expenditure of the local governments.
Dependency of local governments on fiscal transfers from the central government is mainly driven by a large gap
between fiscal capacity and fiscal needs of local governments in Indonesia. In the long run, this would lead to fiscal
mismatch or fiscal unsustainability. One consequence of such a mismatch is the dominant role of intergovernmental
transfers in local budgets that influencing local governments performance in delivering decentralised functions given
to them. Furthermore, intergovernmental transfers from the central government to local governments are generally
given to ensure that local governments can achieve the basic priorities of the development goals set by the central
government in all local government areas, not to finance the local specific-development goals. A higher fiscal
mismatch is an evidence of a weakness of fiscal sustainability which refers to the ability of local governments to
finance expenditure using own-source revenues and at the same time reduce dependency on fiscal transfers from
higher levels of government (Bird, 2003). Fiscal sustainability also indicates long-term ability of government to
fulfill their responsibilities to stakeholders, community (Chapman, 2008). If local governments have not been able to
achieve fiscal sustainability, it will affect their ability to implement public services provision at local jurisdictions
which at the end would hinder the local economic development and sustainable provision of public services.
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Fiscal Desentralisation and Sustainable Development: Lesson from Local

Article in Asia-Pacific journal of rural development · July 2016

The 9th International Indonesia Forum Conference View project

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and public sector activities such as:

Pillar 1 Pillar 2 Pillar 3 Pillar 4

Expenditure Assignment and its Principles

Figure 2. Basic taxonomy of intergovernmental transfer

General-Purpose Transfers Selective-Purpose Transfers

Source: Own figure

General-purpose Transfers (GPTs)

Figure 3. Effect of unconditional non-matching grant

Source: Adapted from Shah (1994), as cited in Shah (2007, p.3)

Specific-purpose Transfers (SPTs)

Figure 4. Effect of matching transfers

Source: Adapted from Shah (1994) as cited in Shah (2007)

Figure 5. Effect of conditional non-matching grant

Source: Adapted from Shah (1994) as cited in Shah (2007, p.5)

Source: own calculations based on data from Ministry of Finance.

Island 2001 2002 2003 2004 2005 2006 2007 2008

Nusa Tenggara, Maluku &

Source: own calculations based on data from Ministry of Finance.

*as a percentage of GDRP

Island Total revenue Own-source revenues Balancing funds

Kalimantan 29.2 1.6 26.0

Source: own calculations based on data from Ministry of Finance

Source: own figure based on data from Ministry of Finance.

Figure 4.Current and capital expenditures by main islands, average, 2001-2008

Source: own figure based on data from Ministry of Finance.

Revenue Decentralisation and Financing Capacity of District and City Governments

Figure 10. Revenues as percentage of total revenues, average, 2001-2008

Other source of revenues, 5.5%

Balancing funds, 86.8%

Own-source Revenue, 7.7%

Source: own figure based on data from Ministry of Finance.

Own-source Balancing funds Other sources of Total

Numbers in parentheses are shares to total revenues

Table 4. Financing capacity of district and city governments (Trillion IDR)

Own-source Total Financing

Intergovernmental fiscal transfers to District and City Governments

Table 5. Balancing funds to district and city governments, (Trillion IDR)

The Revenue and Expenditure Provincial Governments

Island Total revenue Own-source Balancing funds

Kalimantan 4.4 1.6 2.7

Source: own calculations based on data from Ministry of Finance.

Source: own calculations based on data from Ministry of Finance.

Source: own calculations based on data from Ministry of Finance.

Island Total Capital expenditure Current expenditure

Jawa & Bali 2.5 1.6 0.9

Kalimantan 3.6 2.1 1.5

Sulawesi 3.4 2.1 1.3

Maluku & Papua

Source: own calculations based on data from Ministry of Finance.

Source: own calculations based on data from Ministry of Finance.

Source: own calculations based on data from Ministry of Finance.

Revenue Decentralisation and Financing Capacity of Provincial Level

Figure 19. Structure of provincial revenue, average, 2001-2010

Other source of revenues, 5%

Balancing funds, 57%

Own-source revenue, 37%

Source: own calculations based on data from Ministry of Finance.

Table 8. The structure of provincial revenues, average 2001-2010 (%)